Has housing bottomed? Most economists say no

WASHINGTON (MarketWatch) -- Encouraging data on the housing market in the past few weeks have some observers insisting that the worst is over. But others say the small improvements are merely statistical blips and that the market still has much further to fall.

Depending on who's right, the economy could either bounce back from the current soft patch and reaccelerate next year, or it could continue to weaken, forcing the Federal Reserve to cut interest rates to stave off an abrupt economic chill or an outright recession.

Arguing that real-estate woes have hit bottom, we have former Fed Chairman Alan Greenspan, who told an audience in Canada that "I suspect that we are coming to the end of this downtrend, as applications for new mortgages, the most important series, have flattened out."

"I don't know, but I think the worst of this may well be over," Greenspan said. See full story.

Greenspan's old sidekick, Fed Vice President Donald Kohn, concurred, saying, "starts may be much closer to their trough than to their peak." See full story.

On the other side, we have current San Francisco Fed President Janet Yellen, who told an audience in California that "a significant buildup of home inventory implies that permits and starts may continue to fall, and the market may not recover for several years." See full story.

The great debate

The two former rivals and colleagues on the Fed board are joined by dozens of private-sector economists and academics, all arguing vociferously about where housing is heading and what it means for the economy.

The recent housing data have been surprisingly good, bolstering the optimists' view that the market is at least beginning to flatten out.

Just this week, the Realtors reported a decline in inventories of unsold homes, even as sales fell to a three-year low. See full story. The Commerce Department said sales of new homes rose for the second month in a row, sparked by huge price discounting by the builders. See full story.

As reported earlier in the month, the home builders' confidence index rose slightly in October after plunging for eight straight months to a 15-year low in September. See full story. Housing optimists were also encouraged by the 6% increase in housing starts in September after they fell to a three-year low in August. See full story.

Largely unnoticed in their glee was the 6% decrease in the less-volatile building permits data, the fastest pace of decline in seven years. And median home prices are falling at the fastest pace in decades.

The monthly data are interesting but ultimately volatile and unreliable. What we want to know is where's the bottom?

Is it true, as David Seiders, chief economist for the National Association of Home Builders, suggested, that the market "may be stabilizing"? Or as David Lereah, chief economist for the National Association of Realtors, put it a month ago: "We think the housing market has now hit bottom."

The housing optimists are led by economists for two industry groups, so their views may be self-serving to some extent. But their ranks also include some of the more respected economists on Wall Street as well.

"The housing market shows signs of stabilizing, said Dean Maki and Julia Coronado, economists for Barclays Capital, who, like Greenspan, point to the flattened out of mortgage applications as a key indicator.

David Greenlaw, an economist for Morgan Stanley, is another optimist, relatively speaking. . "While we certainly do not think the housing market recession is over, a variety of incoming data increasingly suggest that the worst of it occurred in the third quarter -- and with little meaningful spillover into other sectors of the economy," Greenlaw said.

While some economists saw a bottoming in last week's data, the far-more-common reaction was like this from MFR economist Joshua Shapiro: "It is clear there remains a deep-seated pessimism on the part of home builders."

Or this from Ian Shepherdson, chief economist for High Frequency Economics: "It isn't over. It has barely begun.'

Or this from Bart Malek of BMO Nesbitt Burns: "We have not yet seen the full fallout from the housing correction."

Mortgage applications

The rebound in mortgage application due to lower rates is a key element in the optimists' case.

The increase in purchase applications and the small one-point rise in the home builders' index "is encouraging," said Mike Englund, chief economist for Action Economics.

After falling about 20% from the peaks, applications for purchase loans have been roughly flat for the past three months, the Mortgage Bankers Association reports, even as average rates on a 30-year fixed loan fell a half of a percentage point from about 6.80% to 6.30%. See full story.

At the same time, home prices have also fallen. The combination of lower interest rates and lower prices makes houses much more affordable.

The tiny positive response to a huge drop in interest rates was laughable, the pessimists said.

"That all we could muster was a mere one-point increase [(in the home builders' survey] should actually be a source of concern to the 'soft-landing' advocates," said David Rosenberg, chief North American economist for Merrill Lynch,

"This is a vivid sign that lower interest rates alone will not revive the housing market," Rosenberg said. It'll take a severe drop in new construction before the excess inventory can be worked off.

"We are barely into the fifth-inning of this down cycle," Rosenberg said.

Anyone who thinks a little drop in interest rates will bring back the good old days is delusional, said Paul McCulley, managing director of fixed-income giant Pacific Investment Management Co., recalling that the housing bubble seemed "impervious" to rate hikes in 2004 and 2005

"Housing is going to be very inelastic to falling interest rates on the way down, just as it was very inelastic to rising rates on the way up," McCulley said. "To think otherwise after a bubble is to not understand bubbles. Risk appetite in property markets will not be restored by modest declines in market-determined interest rates."

Real estate is "the ultimate momentum market," McCulley said. "Can't get enough on the way up and can't run away fast enough on the way down."

Real rates

The decline in mortgage rates is deceptive, said High Frequency Economics' Shepherdson, who argues that what really matters to buyers is the real rate, not the nominal one.

The "real rate" means the rate adjusted for inflation. You could adjust it for the increase in the consumer price index, but it makes more sense to adjust it for the change in housing prices.

If housing prices are rising at 10% a year, then a 10% mortgage rate is effectively costless even before tax savings, he says.

Shepherdson figures that real mortgage rates were sharply negative a year ago. When lending rates were at 6% and prices were rising 16% year-over-year, the real rate was negative 10%. Now that prices of existing homes have fallen by more than 2% year-over-year, the real mortgage rate is more than 8%. The turnaround of 18% in real rates dwarfs the half point drop in nominal rates.

"The link between real mortgage rates and home sales is very strong," Shepherdson said. "It screams that home sales will fall much further."

The real mortgage rate is likely to continue to climb as prices fall.

Jan Hatzius, chief economist for Goldman Sachs, figures that selling prices will fall about 3% in 2007 in both the realtors' index of median sales prices and in the more comprehensive price index published by the Office of Federal Housing Enterprise Oversight. The OFHEO index has never fallen in any calendar year.

Pimco's McCulley figures that, based on historic relationships, if house price appreciation is zero in 2007, home sales will fall about 2.5 million from the peak to 6 million by January 2008. By that reckoning, we aren't even half way into the correction.

As in any rapidly rising or falling market, there are plenty of people who swear they've seen the turning point and just as many who swear the end is nowhere in sight. History teaches us to be humble about predicting markets, particularly exuberant ones.

Remember the Dow 36,000 predictions in made in late 1999? Or how about this gem from President Hoover in May 1930: "While the crash only took place six months ago, I am convinced we have now passed the worst and with continued unity of effort we shall rapidly recover."

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